How Some High-Income People Avoid Paying Federal Income Tax

Most of the 43 percent of Americans who the Tax Policy Center projects will pay no federal income tax this year make very little money. Some are middle-income households that qualify for enough tax preferences to zero out their tax bills. But more than 70,000 households with income over $200,000 will pay no federal income tax in 2013. How will they do that?

Some have very high medical expenses but the two biggest reasons are linked to their investments: foreign tax credits and tax-exempt bonds.

TPC’s hit video explains why the 43 percent pay no federal income tax. But for a closer look at why high-income households pay no income tax, it helps to turn to the IRS’s Statistics of Income (SOI) division.

Each year, SOI focuses on two overlapping groups of returns with income over $200,000: those who pay no income tax to the U.S. and those who pay no tax worldwide.

The first includes people whose U.S. liability is zeroed out by domestic tax preferences combined with foreign tax credits and the exclusion of overseas income taxed abroad. The second includes only those who don’t pay any net income tax at all. The analysis also uses two alternative measures of income to define high-income tax units: adjusted gross income (AGI) and “expanded income,” which adds excluded income such as tax-exempt interest and untaxed Social Security. (The second measure is closer to—but not the same as—the Tax Policy Center’s “expanded cash income.”)

The latest installment of the SOI analysis found that about 3 percent of the 143 million tax returns filed in 2010—4.3 million—had expanded income over $200,000. Almost 33,000 (0.8 percent) paid no tax to the IRS in 2010 and about half of those paid no income taxes worldwide.

Nearly 40 percent of those paying no domestic income tax benefitted most from the foreign tax credit and roughly another third saved most because of tax-exempt interest. Various itemized deductions mattered most for about 15 percent of tax filers.

Among those who had no worldwide tax liability, coupon-clipping was the biggest reason. Fully 60 percent of the 16,000 returns paying no net tax benefited most from tax-exempt bond interest. Extraordinary medical expenses, which are currently deductible to the extent that they exceed 10 percent of AGI, were the main reason why another 11 percent of high-income households paid no tax.

It’s likely that some taxpayers save a lot by using tax avoidance techniques that don’t show up in the SOI data. Some of the most successful tax shelters simply defer or otherwise mask income so that a well off person can appear to have relatively modest means.

Most of the high-income tax filers who don’t pay income tax hardly get off scot-free. Those who don’t pay the IRS because of foreign tax credits obviously ante up to other countries. Those who benefit from the exclusion of municipal bond interest pay an implicit tax since tax-exempt bonds earn a lower interest rate than taxable bonds. And, of course, high-income households pay many other taxes. But for a small group of lucky duckies, our current system of tax preferences makes it possible to avoid paying any federal income tax.